Okay, when you become a central banker, you are taken into a back room and they do a DNA change on you. You are henceforth and forever genetically incapable of allowing deflation on your watch. It becomes the first and foremost thought on your mind: deflation, we can't have it.

MV=PQ. This is an important equation, right up there with E=MC2. M (money or the supply of money) times V (velocity -- which is how fast the money goes through the system -- if you have seven kids it goes faster than if you have one) is equal to P (the price of money in terms of inflation or deflation) times Q (roughly standing for the Quantity of production, or GDP)

So what happens is, if we increase the supply of money and velocity stays the same, and if GDP does not grow, that means we'll have inflation, because this equation always balances. But if you reduce velocity (which is happening today) and if you don't increase the supply of money, you are going to see deflation. We are watching, for reasons we'll get into in a minute, the velocity of money slow. People are getting nervous, they are not borrowing as much, either because they can't or the animal spirits that Keynes talked about are not quite there.

To fight this deflation (which we saw in this week's Producer and Consumer Price Indexes) the Fed is going to print money. A few thoughts on that. The Fed has announced they intend to print $300 billion (quantitative easing, they call it). That is different than buying mortgages and securitized credit card debt -- that money (credit) already exists.

When they just print the money and buy Treasuries, as with the $300 billion announced, they can sop that up pretty easily if they find themselves facing inflation down the road. But that problem is a long way off.

Sports fans, $300 billion is just a down payment on the "quantitative easing" they will eventually need to do. They can't announce what they are really going to do or the market would throw up. But we are going to get quarterly or semi-annual announcements, saying, we are going to do another $300 billion here, another $500 billion there. Pretty soon it will be a really large total number.

When we first started out with TALF and everything, it was a couple hundred billion, and now we just throw the word trillions around and it just drips off of our tongues and we don't even think about it. A trillion is a lot. It's a big number. And the total guarantees and backups and all this stuff we are into -- I saw an estimate of $10-12 trillion. That's a lot of money.

Understand, the Fed is going to keep pumping money until we get inflation. You can count on it. I don't know what that number is; I'm guessing maybe as much as $2 trillion. I've seen various studies. Ray Dalio of Bridgewater thinks it's about $1.5 trillion. It's some very big number way beyond $300 billion, and they are going to keep at it until we get inflation.

Side point: what happens if the $300 billion they put in the system comes back to the Fed's books because banks don't put it into the Libor market because they are worried about credit risks? It does absolutely nothing for the money supply. Okay? It's like, goes here, goes back there -- it doesn't help us. The Fed has somehow got to get it into the financial system. They've got to figure out how to create some movement.

Will it create an asset bubble in stocks again? I don't know, it could. Dennis [Gartman] talked about being nervous yesterday. I would be nervous about stock markets both on the long side, as I think we are in a bear market rally, but also there is real risk in being short. Bill Fleckenstein will be here tonight. He is a very famous short trader. He closed a short fund a couple of months ago. He says he doesn't have as many good opportunities, and basically he's scared of being short with so much stimulus coming in. So it's going to work, at least in terms of reflation, but the question is, when? A year? Two years?

Financial Innovation: The Round Trip

Financial innovation is one of the drivers of the velocity of money. We started in approximately 1991 creating the first securitizations and CDOs. It was done at Merrill Lynch, if I remember right. But they started getting copied, and then we went into warp speed, creating all kinds of new CDOs and SIVs that invested in loans, securitized mortgage debt -- most of which was rated AAA -- banks loans, credit card debt, etc. Without thinking about it, we created a shadow banking system that funded a huge chunk of our total credit markets. It was outside the bailiwick of the normal regulatory authorities.

Then in 2007 we began to destroy the shadow banking system. If it was working so well, why did we do that? Because they mismatched their liabilities and assets. They were borrowing short-term and lending long-term, and doing it highly leveraged. They were buying up long-term assets at 4-5-6%, some (or most) of them rated AAA. Then they were selling commercial paper at 1% or 2% -- so you get a 2-3% profit spread.

A 2-3% spread doesn't really make you anything, you're not really excited about that; so since we're dealing with AAA investments that everyone believes to be absolutely safe, let's leverage it up 6-7-8 times. Now you're talking a 20% return. Now you're talking about making money, real money. And I should note that we were also talking real commissions and monster bonuses.

I think one other side note needs to be made here. In hindsight, we can now look back and wonder what the investment banks were thinking. They "must" have known they were pushing bad paper into the system.

But their behavior tells us they didn't know. If they really believed they were, there would not have been so much of the toxic debt left on their books. Bear Stearns launched very large funds to buy this debt at obscene leverages and sold it to their best customers. At least some people in management thought there was real value in these securities, which just goes to show how lax or ignored the risk managers were in all parts of the financial industry.

Then it all began to implode, because people started paying attention to some of the assets on the balance sheets of the various SIVs and CDOs and suspected they might not be worth what they had originally thought. You have subprime mortgages in your Special Investment Vehicle? Hey, I'm not going to buy your commercial paper. Suddenly, the commercial paper market simply imploded. This was the start of the banking crisis.

So we started taking the innovation of securitizations off the table. The innovation that had driven the velocity to new highs was now slowly being pulled off. So, velocity slows down, and it's continuing to slow down with each passing month.

Let's survey the economic landscape. We have an unstable economy. Housing doesn't bottom until 2011 or 2012, unless, as I wrote the other day, we give immigrants a green card to come here. We need the immigrants anyway. We need smart immigrants. By the way, I've never had as much response to my letter, both positive and negative. It ran about 60/40 for. Many of the "against" were people outside of the US, saying why are you trying to take our best, we need them. I suppose there is a certain logic to that, but if we could pull a million homes off the market, it would solve a big part of the US credit crisis right now, not to mention, we would have people putting money into our system and it wouldn't cost taxpayers anything.

But back to the current scene. Consumer spending is slowing, and it's going to slow for years as savings increase. At one time we were savings 7-8-10% of our incomes, back in the early '80s. We grew from 63% of the economy being consumer spending, to 71% in 2006. We are going back to the mid --to low 60s in terms of the percentage of consumer spending in GDP. We are not doing it all at once, it's going to take years; but, gentle reader, it's the blue screen of death! We are hitting the reset button.

Economists have a term for this process. It's called rationalization. We have too many stores to sell "stuff," all sorts of stuff. Too many malls. We have too many factories to build too many cars, too many plants to build too many widgets for an economy where 65% of GDP is consumer spending. When we built all that capacity it was for an economy in which consumer spending was 71%; and because we were enthusiastic and believed we would grow at 3% forever, we probably built it for 73% or 74%.

We are watching capacity utilization fall off the table. It is down to 67%, fully 15% below normal. What happens when you see that? You start closing factories. It's just what you have to do. We are going to have fewer restaurants, fewer clothing stores. The survivors will get bigger market shares; that's just what happens. Schumpeter called it creative destruction.

And this being a different type of recession -- because we are hitting the full credit-cycle reset, it's going to take longer. I think the recession -- the actual, honest, mark-to-market numbers --will be negative through 2009. Then we'll start to improve. This current first quarter is going to be ugly again, then it will be a little better in the third quarter. The second quarter -- I don't know how bad it's going to be, but it's not looking good.

But in 2010 we could start seeing slow growth again, maybe Muddle Through. There might be a sluggish recovery in 2010, but we have to put an asterisk on that possibility because the Democrats are going to push through the largest tax increase in history.

First of all, the tax increase is the Republicans' fault. They didn't make the tax cuts permanent when they had the chance, so consequently they go away in 2010. US taxes are going to go way up, whether there is no compromise, so that we go back to the pre-Bush years, or there is some compromise because the Obama Administration realizes that putting in that type of a tax increase will throw us back into recession. Remember Roosevelt? What did he try to do? He raised taxes in the middle of a recession (1937), when unemployment was 14%, driving it back up to 20%. Unemployment will be 10% or 11% by this time next year, and maybe by the fourth quarter.

If you count those who are working part-time but want full-time employment, the unemployment number is closer to 15%. Yesterday, my taxi driver was a mechanical engineer who lost his job, but had kids and had to do whatever he could to put food on the table. He said there are a lot of people like him here in California.

The deficit is going to explode way past $2 trillion unless somebody can show some sense. Let's look at the carbon credit problem. Obama wants to impose this new carbon credits program, which sounds benign. We call it a credit and not a tax. Here's the issue. It gives us two bad possibilities, one of which is going to happen. Number one, he is assuming there is something like $800 billion coming in over the next decade from these carbon credits, and he's put that as income in his proposed budget, like it's going to get passed into the system. He is assuming that revenue. If he doesn't get it, deficits are much higher in the near term.

But if he gets it, it's even worse, as US industry becomes uncompetitive with Third World industries that don't have the same carbon credits and energy costs. Do you think China or India will pass the same legislation? They are building more coal-fired plants every month than we build in a year.

We are going to be seeing factory after factory shut down and moved off-shore, because they simply won't be able to compete. Either way, we go back to that economics technical term I used earlier: we're screwed. The carbon credits program is just a massively bad idea. There are things that we should do to cut down energy usage, but this is not the way to go about it. We can talk about other ways to do it if you want to.

2010-11: Back to the Future Recession

I think the country could re-enter a recession in 2010 and 2011; we would go right back into it when those tax hikes start to hit. What do tax increases do? They take money out of consumers' pockets -- and the consumers that actually spend. Plus, 75% of those who will see their taxes rise are small businesses that employ people, so we deflate ourselves.

Liberal economists are going to argue, "Wait a minute, John. We are taking it from these [rich] guys, but we are giving it to lower-income families, so it will get spent." But it's going through the government -- we don't get the same bang for our buck. We don't get new employment. We're simply transferring and creating a new welfare state; plus, we have a number of recent studies which show that the propensity now is not to spend the new money but to use it to pay down debt. This is not a pro-growth policy, and growth is what we need. Not wealth transfers and a new welfare state.

At some point inflation starts to show up again, because when you start running two-trillion-dollar deficits and you start trying to borrow it, at the same time the Fed is printing money, at some point in this process the bond markets (and the currency markets) are going to rebel. An unsustainable trend will keep going until it stops. I don't know when that day is, but the current policies mandate that we will hit the proverbial wall. One day it will be just like August 2007. Someone is going to ring a bell and the Treasury bond market is going to look the deficits and wonder how they will fund them, and they are going to let out a huge gasp and then throw up. Because you can't run two- to three-trillion-dollar deficits as far as the eye can see.

As Woody Brock so capably points out, the key to watch is the debt-to-GDP ratio. You can grow debt fast; but at some point you start to have to grow the economy faster than you are growing debt, or you become an economic basket case, where the dollar is devalued and interest rates go up fast. At that point, the Fed will have lost control. The key item to watch now is the budget debates. Are we going to build in $2 trillion deficits, or we will show some fiscal restraint?

The Fed at the Crossroads

And, are we going to try and do this when unemployment is at 10% or more? The Fed at some point is going to come to a crossroads. They can allow inflation, like the '70s. (And some of us are old enough to have lived through the '70s, though I really didn't notice much -- I actually made money on inflation during the '70s. I was in the printing business before I went into the investment publishing business. I would buy traincar loads of paper on credit and put it on warehouse floors; and because I was the only guy who could get paper and I had it at a good price, I got a lot of business. So I made money off of that inflation cycle.

We figure out how to Muddle Through, even during periods like the '70s. So the Fed can bring that back -- which they all swear they won't do -- or they can withdraw liquidity. What happens if they withdraw liquidity? It slows the economy down, because we are pulling money out of the system. Just as higher interest rates begin to take a toll on the economy, they will have to start pulling money out of the system to avoid higher inflation. By the way, if rates are rising that means the interest payments on the federal debt are rising, because we have a lot of short-term federal debt. Frankly, as a government, we should be buying all the 30-year bonds we can possibly buy. But we are not, because that would increase the pressure on the current debt. We have the long-term forecasting ability of a mongoose.

We are in the middle of a Great Experiment, the one truly great experiment of this time; so the economists are fascinated. We have Keynes versus von Mises versus Irving Fisher versus Friedman, and they all have theories about what you should do after depressions and what works. Someone commenting on Keynes said, "In a world organized in accordance with Keynesian specifications there would be a constant race between the printing press and the business agents of the trade unions. With the problem of unemployment largely solved, the printing press could maintain a constant lead."

Printing money. That's what the current Fed is doing. Just as aside, here is a great quote I came across. It really doesn't have anything to do with anything, but it's fun. John Ehrlichman told us about a conversation between Richard Nixon and Arthur Burns, who was Nixon's nomination to be Chairman. Nixon said, "I know there is the myth of the autonomous Fed [short laugh]. When you go up for confirmation some Senator may ask you about your friendship with the President. Appearances are going to be important, so you can call Ehrlichman to get messages to me, and he'll call you." I'm sure that's not done today.

Seriously, the independence of the Fed is critical, Nixon notwithstanding. Given the recent revelations about Bernanke and Paulson supposedly telling Ken Lewis at Bank of America not to tell the public about how bad the Merrill situation was -- do you think there might possibly be some pressure on Bernanke? His term is up early next year. It is quite possible we get a Fed chairman who would be more accommodative of a left-wing agenda than Bernanke, who I believe really will pull back from allowing inflation to get too high.

This would force budgetary discipline on Congress, which the left will not like. I can see some real issues in the upcoming nominating process if Bernanke is not left at the helm. Do we really want Larry Summers?

Let's get back to our discussion of the Great Experiment. Von Mises said there is nothing you can do about a deleveraging cycle, you basically just let it all go to hell and then pick up the pieces. The hair-shirt economists, I call the Austrians: just let it drop, take your medicine, take your 15-20% unemployment, and just deal with it, because you'll be able to come back faster from the lower base. By the way, to von Mises, the velocity of money was a meaningless concept. Gold was where you should have had your money to begin with.

Then there is Friedman, who produced his great work that says inflation is always and everywhere a monetary phenomenon. He had his studies to prove it. But when he did his studies, in the 30 years that he analyzed, the velocity of money was remarkably stable. So of course, inflation had a 1-to-1 correlation with money supply.

Fisher says, "The velocity of money is important." For Fisher, debt deflation controlled all other economic variables. It was the driving economic force. You're going to have to rationalize all your debts. There's nothing you can do about it; but what you do is, do as much as you can to provide a soft landing for the people who lose their jobs. Do whatever you can to get them along and to keep the system working, but you are still going to have to go through a credit reorganization. We are going to find out in 5-6 years who was right. That is the experiment we are living through. My bet's on Fisher, just for the record.

How Did We Get It So Wrong?

So how did we get it so wrong? How did we get here? Let's go back to first principles: Ideas have consequences. And bad ideas tend to have bad consequences. We've taught two generations of financial managers theories that were patently absurd. Rob Arnott is going to be here later with us for the panel discussion. Rob recalls standing in front of 200 academics, professors in schools that teach economics. He asked them, "How many of you believe in the efficient market hypothesis?" Something like two or three raised their hands. "How many of you teach it?" All of them raised their hands.

We have been teaching generations of MBA students economic garbage. Gaussian curves and things you could model. The classic line is from Ibbitson, is a brilliant professor and a brilliant mind, who said economics is a science. No it's not. It's barely an art form. It's voodoo. That's what we practice. We look at the entrails of the Wall Street Journal and try to predict the future. Sometimes it's about as bloody as sheep entrails. CAPM... poor Harry Markowitz's Modern Portfolio Theory got so twisted beyond recognition. I remember being with Harry Markowitz. I gave a speech at a big hedge fund conference about five years ago, talking about why Modern Portfolio Theory was not going to work. The next year it was the 50th anniversary of Modern Portfolio Theory, and they brought Harry out to speak. He of course talked about why it was. I remember meeting him in the hall of this big hotel. And I asked him a couple of questions; I forget what they were because he so staggered me with, "Oh, you missed the whole concept of correlation and assets. Correlations change."

And he started drawing quadratic equations in the air. But because I was standing in front of him, he was drawing them backwards so I could see them. I mean, this guy is absolutely brilliant. But he's right, you should have a diversified portfolio of noncorrelated assets; but as John was showing yesterday, correlations in a crisis all go to one.

What money managers did was to create models that said, "If you do this, diversify your portfolio like this, and here are all your noncorrelated asset classes -- see what happens? You get long-term positive results."

And they would project that into the future. But they didn't project crises, when correlations go to one. Modern financial theory only works in models if you assume a few things that are patently not true in the real world. So we trained a generation of managers and investors that they should buy 60% stocks and 40% bonds. Yet for the last 40 years, bonds have outperformed stocks. Where was that in the model?

Well, we can go back to the 19th century and see it. But we created a trend from 1944 to 2000 that said we were going up, and we trained a generation to believe they could model, and they did it. They modeled garbage, and now we've wiped out a generation of retirement income. I could go on and on, but it's nonsense.

We let the rating agencies become way too important. They were supposed to be the adults supervising the sandbox, and they weren't. They started out perfectly acceptably, but then they decided they wanted to rate multiple-obligor securities like real estate mortgage bonds using the same ratings they used for corporate bonds. They sold their business souls and didn't even realize it.

Remember, we trained a generation of people to think they could model this stuff. So they modeled what potential defaults would be, based on past performance, and not even past performance that looked like the assets in the investments they were rating. But it was scientific and looked like the models they learned in school.

Every time you get a letter from me, there is a page and a half down there at the bottom, full of disclosures. At least twice in those disclosures I say past performance is not indicative of future results. It's like, "coffee is too hot, don't spill it." We don't pay attention to it, but it's the most important thing, because past performance has nothing to do with future history.

The future is going to look different, yet we think we can model it. The models are bullshit. (That's a technical economics term that requires advanced degrees to use.) They just are. Now you can take some comfort from them, and you have to try and figure stuff out, and you look for correlations. That's what I do, and we all do that. I confess I use models every day.

But you have to recognize that the model has a huge asterisk beside it. You just can't bet the farm on it. And God, have I learned that the hard way. I've got bruises on my back from making assumptions. That's why I don't go around half-naked, because it would just look ugly.

We let the rating agencies use a corporate bond-rating system -- AAA, AAB -- for multi-obligor bonds that had nothing to do with reality, and they rated them up on the way up and now they are rating them down on the way down, and they are screwing us both ways. Because if you lose 1% on a triple-A bond, it immediately goes to junk. That means the banks have to write it off their capital and sell it for 50 cents on the dollar.

When did this problem start? July of 2007, when we introduced mark-to-market accounting. When did AIG have a problem? When they had to start writing their AAA's down. Now we should never have let it get to that place to begin with, but now we have to deal with reality. You can't just sit there and say, "Tsk, tsk, we need to let these guys go bankrupt."

No, you can't, not unless you want 25% unemployment again. We have "X" amount of pain to go through to get back to whatever the "new normal" will be. Think of this as a big tube of pain, OK? We can do it in one year or in seven or eight years. I vote for seven or eight. I don't want 20-25% unemployment. I would rather have 10% unemployment for seven years. Now, that's just me, because I know when my neighbor is unemployed, when my kid is unemployed, that it hurts.

The Trend Is Not Your Friend When It Ends

So, the establishment is now saying, "Let's keep the system going." Now, are we going to have problems when the Fed starts trying to pull the extra cash they are printing out of the economy? Yes. Is that going to create a different form of future history than we have experienced in the past? Yes. Therefore, trying to model the future based upon that past, will not work.

We believed the trend. The trend is not your friend when it ends. OK? It just isn't. Now, I'm the guiltiest person in the world. I live on what one of my friends calls "psychic income." That is the income you get when you take a current business model, the current business you are in, and you say, if I could grow these assets to "Y" I would make "Z". That "Z" charges me up. I haven't earned it yet and the train probably won't go there, but it gets me up in the morning. That's my psychic income. We all do that. But we rarely realize that it's just psychic income; it's not real income until the cash is there.

Given all that I have said, I still contend I am not a pessimist, at least not in the long term. Stocks go from high valuations to low valuations to high valuations. They've done it in US markets and world markets, and we are halfway through the trip in a secular bear market. We haven't gotten to low valuations yet, I don't care what they say. The P to E at the end of July was something like 289 on the S&P. You can go to the S&P website and you can see that. Now you smooth it with five-year curves and performance, and it goes to 20. 20 is not cheap. But it's going to get cheap -- at least that's what history tells us.

Now maybe history is wrong, because past performance is not indicative of future results; and I could be wrong, but sometimes you just have to set an anchor and say this is what I'm believing. I think we are going to lower valuations, and when that happens we will have compressed price to earnings ratios just like we did in 1982. The world will be coming to an end and we'll be moaning and groaning. We haven't gotten as bad as we were in '82 -- whoever pointed that out is correct.

But what will happen? The stock market will be a coiled spring and we'll have a bull market and we'll get to have fun in the stock market again. Until then, be careful.

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. Contact John at John@FrontlineThoughts.com.

Disclaimer
John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.